Valuation Commentary

Valuation Q&As. Part 2: Valuation of MBS with OAS and prOAS
by Alex Levin

Methodology

Q. Many instruments are still valued using the static method… Is OAS truly necessary?
A. If we review our mathematical education and knowledge (ranging from Calculus I to a PhD), we will find a single intuitive motivation for every theorem, lemma or solution technique and that is our desire to express the unknown through the known. In finance, we strive to compute the unknown price of an MBS using known prices of other fixed-income instruments. Unfortunately, no static measure can be strictly derived for an MBS using direct relationships to other instruments. It is impossible to postulate a well-defined rule that would point us to the right yield or Z-spread to use.

MBS are embedded-option instruments and, as such, should be valued using adequate techniques. For example, options are not valued using a single interest-rate path and nor should MBS. The OAS approach is just an extension of option pricing. Indeed, any option pricing can be considered an application of the OAS method– just with OAS set to zero.

Perhaps the only reason some practitioners still employ the static method is that MBS are bonds with options, not just options. If we applied the static approach to options, we would get nonsensical values.

Q. How many paths…?
A. The October 2003 Pipeline discusses this subject by documenting accuracy when pricing various pass-throughs. Since the release of version 5.2 in July 2004, our OAS system has been reporting sampling accuracy in computing either price or OAS. Note that version 6.0 and above allows for pricing pass-throughs via backward induction– no random paths are used. The CMO universe is very vast and may include features such as “sticky jumps” that require a large number of paths to be properly valued. In practice, cashflow vendors parse non-agency CMOs and ABS deals that are slower than agencies which leads to accuracy limitations. We experience no problems running 500 - 1000 paths for agency CMOs, but see slow processing when running even 100-200 paths for some complex-collateral non-agency deals.

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